The eurozone is in "critical" danger but can restore credibility with urgent action for a banking union, with some form of eurobonds, and if the ECB ramps up injections of cash, the IMF said on Wednesday.
The European Central Bank should pull harder on its levers of special measures to buy government debt and fund banks, and should be open about its targets, the IMF said.
In a hard-hitting review of policies for the euro area, it warned: "The euro area crisis has reached a new and critical stage.
"Despite major policy actions, financial markets in parts of the region remain under acute stress, raising questions about the viability of the monetary union itself."
A worsening of the crisis would have a big impact on neighbouring European countries "and the rest of the world."
It warned: "A determined move toward a more complete union is needed now."
On growth, the International Monetary Fund said that the "stark" truth was that eurozone countries had lagged the best performers for 50 years.The euro is slightly over-valued by zero to 5.0 percent, the IMF estimated, but some countries in crisis needed a much bigger adjustment, of 5.0-10.0 percent for Italy and 10.0-15.0 percent for Spain.
Determined programmes for structural reforms to raise competitiveness were vital, the IMF said, warning also of a risk of deflation and suggesting that strong countries in northern Europe could allow wages and inflation to rise.
EU authorities should be flexible in mobilising new rescue funds (EFSF and ESM) to prevent contagion, for example if a crisis in a big bank threatened the financial system.
These IMF recommendations on eurobonds, inflation in strong countries and the role of the ECB run counter to the line taken by Germany, the main pillar of strength in the eurozone, and the ECB is also reticent about ramping up its special measures.
The view of the IMF is particularly significant because the fund is committed with EU authorities to direct bailouts for Greece, Ireland and Portugal, in defining the conditions and auditing the progress of rescue programmes.
The IMF stressed that the key to growth was further action to put over-strained public finances on a sound basis, coupled with longer-term reforms to increase efficiency.
Even by halving the gap with best practice in other countries and in four areas -- employment and tax laws, and opening up markets for tradeable and non-tradeable goods -- growth could be boosted by five percentage points over five years.
The term non-tradeable goods refers implicitly in part to the public sector.
The IMF prescribed policies which it considered should be pursued urgently. Amounting to a radical adjustment of the so-called European economic model, they said:
- "The first priority is a banking union for the euro area." This must be in line with rules for all 27 members of the European Union but was urgent for the 17 eurozone countries.
It could combine a pan-European scheme to guarantee bank deposits, a "bank resolution" mechanism involving private creditors in the orderly winding-down of a failed bank, and common bank supervision which could be assigned to the ECB for the eurozone.
- This had to be backed by fiscal integration and "more risk sharing" to prevent a shock in one country from imperilling the entire eurozone.
- The "introduction of a limited form of common debt" could be a half-way step towards "fiscal integration and risk sharing," it said in an implicit reference to some form of eurobonds.
- The European Central Bank still had some room to reduce interest rates, could announce a big programme to buy bonds on the secondary market, (known as Quantative Easing), and could announce more long-term operations guaranteeing banks access to cheap funds for several years.
It could also dilute further its conditions for collateral from banks in return for funds.
- Wage and asset price rises and "higher inflation" in northern eurozone countries would reduce a gap between current account surpluses in the north and deficits in the south, and to "reduce the risk of debt-deflation spirals in the south."
- The authorities should make clear that the ECB and the rescue funds would not have priority over private investors in the event of a default. "A clear commitment to accept equal status ... as in the case of Spain" would boost confidence, the IMF said, referring to a rescue for Spanish banks.
- "Long-standing structural rigidities need to be tackled to raise long-term growth prospects", focusing on "improving competitiveness". This was "essential".- Short-term support for growth will also be needed, partly to offset the recessionary effects of budget rigour in countries overwhelmed by debt. Budget correction must be pursued, urgently in the weakest countries and at a measured pace where crisis is less acute.
- "If the crisis escalates, policymakers will have to stand ready to support the euro area banking system, including through a flexible use of the European firewall."
In any case the outlook was bleak, with average eurozone growth set to fall from 1.5 percent in 2011 to shrinkage of 0.3 percent this year and of 0.7 percent next year.
Unemployment rates would remain high this year, from 5.5 percent in Germany to 24.0 percent in Spain, and these differences would persist.
The risk of deflation was low in the faster-growing economies but "significant in the periphery."
The causes of the crisis had not been tackled, the IMF suggested, saying the authorities still lacked the "basic tools" to prevent government debt, banking tensions and low growth from generating a vicious cycle of crisis.